Wednesday, December 10, 2008

Treasury Notes and CDs

My wife asked me why people would buy Treasuries when the equivalent CDs (Certificates of Deposit) pay higher interest rates. Or when you can just put your cash in a sack and not lose money when rates turn negative, as they did yesterday. It is a good question and the answer illuminates the current financial situation.

Short term Treasuries (Treasury bills or T-bills) are paying little, no, or even (as the headlines say today) no interest because their prices are set by auction and right now a lot of people want them. They are perceived (incorrectly) as being the safest liquid money investment there is, which attracts a lot of investors in a time of fear.

CDs at banks, savings and loans, and credit unions are nearly as liquid, and they are backed by federal government agencies up to a set sum per individual per bank. If you have more than the insurable amount (currently $250,000), you can get CD's at a variety of institutions and all of your money will be insured by the federal government.

Interest paid on CDs varies quite a bit by institution and by the amount you deposit and time until maturity, but in general today the interest rate is quite a bit higher than you would get on a treasury that is roughly equivalent. That difference in interest is what we must account for.

Suppose you manage a money market fund, equity fund, or any large, multi-billion dollar pool of money. One day clients may put in ten billion dollars, the next day they may withdraw $20 billion. You have to have enough liquidity to deal with this. You can't get a $1 billion CD one minute and then cash it back in 4 hours later. But treasuries are always being traded. You can by $10 billion or $20 billion in treasuries right now, or sell them at a moments notice. So your clients' panicked stupidity forces you to put their money where it has the lowest rate of return. Also, if you did try to get CDs instead, they would be not be backed by the FDIC. So if the bank that issued them failed, you would be out the money (unlike ordinary CD buyers).

The nature of financial panic is that most people don't panic early enough, so they panic with everyone else, and the auction pricing mechanisms in place bring ruin to them. They also don't emerge from panic early enough, so they miss the big bounces when auction prices turn around.

For those of you who are not familiar with the conventional wisdom, I should point out that:

Only suckers buy bonds when interest rates are low.

Why? Because bonds have what is called principle risk. Suppose you buy a ten year treasury note at 2% interest today. Suppose this liquidity crisis is over in 2010 and in addition has spawned some inflation, so interest rates have gone up to say 8%. You aren't scared any more so you ask your account manager to sell your totally safe $100,000 in 10-year Treasury notes for you. You check your computer the next day and your $100,000 has turned into $25,000 (more really, but I want to keep our math simple). No kidding. So, too late, you ask for an explanation.

If someone buys $100,000 in new securities they can get 8%. So to get 8% from your lousy 2% notes, they can only offer one-fourth the principle.

But could you not save your $100,000 by keeping it until maturity? Of course, that is allowed, but in the meantime it is locked in at 2% interest, or $2,000 per year, when if you could reinvest the same amount you could get $8,000 per year for the following 8 years. $64,000 versus, $16,000.

Of course, I used 8% to magnify the problem, but to any extent interest rates rise, you lose principal if you must sell.

And believe me, the Wall Street guys know how this works. Fortunately for them it is your money, they just get paid for managing it.

We are told banks don't have money to loan right now. The federal government is putting money into its pet banks (including favored institutions that were not even banks before this program began). If the money that had flowed into treasuries had been deposited at banks instead, the banks would have plenty of money to lend.

Think about it. And buy bonds when interest rates are high, so you can make a killing selling them when interest rates are low. Let the buyer beware.